Sarah Bradford explains when tax underpayments can be collected through PAYE via an adjustment to an employee’s tax code.
The self-assessment tax return for 2017/18 normally needs to be filed by midnight on 31 January 2019. However, an earlier deadline of 30 December 2018 applies to taxpayers who have a tax underpayment that they would prefer to be collected through PAYE via an adjustment to their tax code. The option for tax to be collected in this way is also available to taxpayers who filed a paper tax return for 2017/18 by 31 October 2018.
What is coding out?
The tax code determines how much tax-free pay an employee receives (or, in the case of a taxpayer with a K code, the amount of additional income the taxpayer is treated as receiving). The starting point for the employee’s tax code is the personal allowances to which they are entitled. The code may then be reduced to allow tax on (for example) benefits in kind to be collected via PAYE – the available allowances being reduced by the taxable amount of the benefit to arrive at the tax code number.
In the same way, tax underpayments can be collected via PAYE, adjusting the code for the grossed- up amount of the underpayment. The underpayment is grossed up at the taxpayer’s marginal rate of tax to arrive at the adjustment needed to collect the tax underpayment.
Example: Tax underpayment coded out
Julie has a tax underpayment of £700 for 2017/18. She is an employee and pays tax at 40%. She submits her 2017/18 tax return online on 18 November 2018 and opts for the tax underpayment to be collected via an adjustment to her 2019/20 tax code.
The adjustment needed is £1,750 (£700 x 100/40). Tax on £1,750 @ 40% is £700 – the amount of the underpayment.
Julie’s allowances will be reduced by £1,750 to collect the tax on her 2017/18 underpayment of £700 through her 2019/20 tax code.
Why code out?
Coding out an underpayment allows the tax to be collected over the course of the following tax year via a deduction from the employee’s pay. This may be a more palatable option than paying the full amount by the following 31 January.
For example, if an employee has an underpayment of £2,400 for 2017/18, by opting to have the underpayment collected via their tax code, they will pay the tax in interest-free instalments of £200 per month if they are monthly paid. This may be preferable to paying out £2,400 in a lump sum.
What can be coded out?
There is a ceiling on underpayments that can be coded out, and this payment option is only available for self-assessment underpayments of less than £3,000. Coding out is only available if the taxpayer is already within PAYE, either because the taxpayer is an employee or director or is in receipt of a company pension.
Self-assessment underpayments of £3,000 or more cannot be collected via an adjustment to the tax code; although HMRC may collect other tax debts of more than £3,000 in this way, depending on the level of the individual’s income.
50% regulatory limit
The PAYE regulations restrict the amount of tax that can be collected via the payroll. The restriction, which is known as the ‘regulatory limit’, is set at 50% of gross income after taking out deductions from gross pay, such as pension contributions. The purpose of the limit is to prevent undue hardship for the employee as a result of eroding all or most of their take home pay.
Thus, when applying a tax code, an employer must cap the tax deduction at 50% of the employee’s pay. The underpayment will be carried forward to the next pay period. If the employee’s income is not sufficient to have collected the underpaid tax by the end of the tax year, the underpayment cannot be carried forward to the next tax year; although HMRC may concessionally code out the underpayment in the following year if income appears sufficient in that year to facilitate collection. Otherwise, the underpayment will be collected via the self-assessment system.
Where the 50% limit will be exceeded, HMRC will not generally code out an underpayment – there is no benefit in issuing a code that will result in an underpayment at the end of the tax year. There is a hierarchy in coding out, and HMRC will adjust the tax code to collect the tax due on benefits in kind where the benefits are not payrolled and, where the taxpayer is in receipt of the state pension, any tax due on their pension, ahead of coding out self-assessment underpayments.
Action needed
It is perhaps a little dangerous to assume that a tax underpayment will be coded out without checking that the conditions are met.
Coding out is only an option if:
- the underpayment is less than £3,000;
- the taxpayer is already within PAYE; and
- coding out the underpayment will not cause the 50% regulatory limit to be reached.
The taxpayer must also ask for the underpayment to be coded out on his or her self-assessment return.
If all of the above conditions are not met, HMRC may collect the underpayment for 2017/18 via the self-assessment system, with the result that it will need to be paid in full by 31 January 2019, with interest and, potentially, penalties arising if payment is not made by that date.
If coding out is not an option and the taxpayer lacks the funds to pay the underpayment in full, it is advisable to contact HMRC before 31 January 2019 to agree a payment plan, rather than waiting until it is overdue.
Collecting other tax debts via PAYE
Since April 2015, HMRC has also been able to use the PAYE system to collect other tax debts. The legislation allows for relevant debts of up to £17,000 to be collected under PAYE without the payee’s consent; although the maximum that can be collected in this way depends on the level of the payee’s PAYE income. However, the limit for coding out self-assessment balancing payments and PAYE underpayments remains at £3,000.
As regards other tax debts, the extent to which a debt can be coded out depends on the level of the taxpayer’s primary PAYE income, as set out in the table below.
|
PAYE
income |
Coding
out limit for relevant tax debts |
|
Less than £30,000 |
£3,000 |
|
£40,000 -- £50,000 |
£5,000 |
|
£40,000 -- £50,000 |
£7,000 |
|
£50,000 -- £60,000 |
£9,000 |
|
£60,000 -- £70,000 |
£11,000 |
|
£70,000 -- £80,000 |
£13,000 |
|
£80,000 -- £90,000 |
£15,000 |
|
More than £90,000 |
£17,000 |
Where a tax debt is coded out this will be shown on the annual coding notice P2.
The 50% regulatory limit applies where tax debts are coded out.
Practical Tip:
It is advisable not to leave filing the 2017/18 self-assessment return until the last minute, as this will remove the option to have any underpayment coded out – for this to be a possibility, the tax return must be filed online by 30 December 2018, if a paper return was not filed by 31 October 2018. Paying any tax underpayment throughout the year is generally a less painful option than paying it in full in January 2019.
